Assignment 2 - MAA324

Nicolas Kuiper

December 15, 2022

Exercise 11 Consider two scenarios, ω1 with probability 14 and ω2 with probability
3
4 . Suppose that the return on a certain security is R1 (ω1 ) = −2%
in the first scenario and R1 (ω2 ) = 8% in the second scenario. If the
return on other security is R2 (ω1 ) = −4% in the first scenario, find
the return R2 (ω2 ) in the second scenario such that the two securities
have the same risk.

Solution The expected return and standard deviation of security 1 are:

1 3
E(R1 ) = × (−2%) + × 8% = 5.5%
4 4
r
1
2 3
2
σ1 = × −2% − 5.5% + × 8% − 5.5%
4 4
r
1
2 3
2
= × −7.5% + × 2.5% = 4.33%
4 4
For security 2 we have:

1 3 3
E(R2 ) = × (−4%) + × R2 (ω2 ) = × R2 (ω2 ) − 1%
4 4 4
v
u   !2  !2
u1 3 3 3
σ2 = t × −4% − × R2 (ω2 ) − 1% + × R2 (ω2 ) − × R2 (ω2 ) − 1%
4 4 4 4
s  2  2
1 3 3 1
= × − × R2 (ω2 ) − 3% + × R2 (ω2 ) + 1%
4 4 4 4

In order to obtain σ1 = σ2 we need to solve:

 2
 − 3 R2 (ω2 ) − 3% = −7.5% 2


4
 2
 14 R2 (ω2 ) + 1% = 2.5% 2


From the first equation we then have:

− 34 R2 (ω2 ) − 3% = −7.5% ⇒ R2 (ω2 ) = 6%

− 43 R2 (ω2 ) − 3% = 7.5% ⇒ R2 (ω2 ) = −14%

Similarly, from the second equation we have:

1
4 R2 (ω2 ) + 1% = 2.5% ⇒ R2 (ω2 ) = 6%
1
4 R2 (ω2 ) + 1% = −2.5% ⇒ R2 (ω2 ) = −14%

σ1 = σ2 ⇒ R2 (ω2 ) = 6% OR R2 (ω2 ) = −14%

1
Exercise 12 Let the return on an investment be R = 3% or R = −1%, both with
probability 0.5. Now suppose that the return on other investment
is double that on the first investment, also with probability 0.5 each
scenario.
What is the relationship between both product’s risk,
ˆ (i) if the risk is measured by the variance?
ˆ (ii) if the risk is measured by the standard deviation?
Why are these the relationships?
Solution The expected return, standard deviation and variance of the invest-
ment are:
1 1
E(R1 ) = × (3%) + × −1% = 1%
2 2
r
1
2 1
2
σ1 = × 3% − 1% + × −1% − 1% = 2%
2 2
2
σ12 = 2% = 0.04%

If we double the returns, i.e. R = 6% or R = −2% (both with prob-

ability 0.5), the expected return, standard deviation and variance of
the investment become:

1 1
E(R2 ) = × (6%) + × −2% = 2%
2 2
r
1
2 1
2
σ2 = × 6% − 2% + × −2% − 2% = 4%
2 2
2

2
σ2 = 4% = 0.16%

ˆ (i) measured by the variance, the risk increases by a factor of four if

returns double, i.e.
σ22 0.16%
2 = =4
σ1 0.04%
ˆ (ii) measured by the standard deviation, the risk increases by a factor
of two if returns double, i.e.

σ2 4%
= =2
σ1 2%

Exercise 13 Suppose that a portfolio worth W (0) = 1000SEK is constructed by

taking a long position in stock S1 (0) = 30SEK and a short position
in stock S2 (0) = 40SEK, with weights ω1 = 120% and ω2 = −20%
respectively:

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 ˆ (i) How many shares of each type are in the portfolio?
ˆ (ii) If the stock prices change to S1 (1) = 35SEK and S2 (1) =
39SEK, what is then the portfolio value?

Solution ˆ The amount of shares can be calculated as follows:

W (0) × ω1 1000SEK × 120%
s1 = = = 40
S1 (0) 30SEK
W (0) × ω2 1000SEK × −20%
s2 = = = -5
S2 (0) 40SEK
ˆ If the stock prices change to S1 (1) = 35SEK and S2 (1) = 39SEK,
the portfolio value can be calculated as follows:

W (1) = s1 ×S1 (1)+s2 ×S2 (1) = 40×35SEK−5×39SEK = 1205SEK

Exercise 14 Find the return on a portfolio consisting of two kinds of stock with
weights ω1 = 30% and ω2 = 70% if the returns on the components are
as follows:

Scenario Return R1 Return R2

ω1 0.12 −0.04
ω2 0.1 0.07

Solution The expected return of the portfolio can be calculated by:

n
X
E(rp ) = ω(i) × E(rRi )
i=1

Where:

E(rR1 ) = ω1 × r1,R1 + ω2 × r2,R1 = 0.3 × 0.12 + 0.7 × 0.1 = 10.6%

E(rR2 ) = ω1 ×r1,R2 +ω2 ×r2,R2 = 0.3×(−0.04)+0.7×0.07 = 3.7%

Therefore, the expected return of the portfolio is:

E(rp ) = ω(1)×E(rR1 )+ω(2)×E(rR2 ) = 0.3×10.6%+0.7×3.7% = 5.77%

Exercise 15 Suppose that the prices of two stocks behave as follows:

Scenario Probability Return R1 Return R2

ω1 0.5 0.1 −0.05
ω2 0.5 −0.05 0.1

How much is the risk if we split our money equally between these two
stocks? Is it higher or lower than invest only in one of the stocks?

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 Solution The expected return and risk for each individual stock is:

E(R1 ) = 0.5 × 0.1 + 0.5 × (−0.05) = E(R2 ) = 0.025

1 1
σ12 = ×(0.1−0.025)2 + ×(−0.05−0.025)2 = σ22 = 0.0056 ⇒ σ1 = σ2 = 0.075
2 2
The covariance is:
2 h
X

i
σ1,2 = pi × R1,i − E(R1 ) × R2,i − E(R2 )
i=1

1 1
= ×(0.1−0.025)(−0.05−0.025)+ ×(−0.05−0.025)(0.1−0.05) = −0.0056
2 2
Finally, the risk of the portfolio can be calculated by:
 2  2
1 1 1 1
σp2 = ω12 σ12 +ω22 σ22 +2ω1 ω2 σ1,2 = ×0.0056+ ×0.0056+2× × ×(−0.0056)
2 2 2 2

0.0056 0.0056
σp2 = − = 0 ⇒ σp = 0
2 2
If we split the money equally, then the resulting risk is lower than
investing into a single stock.

σ1 = σ2 = 0.075 > σp = 0

Alternatively, the correlation coefficient ρ1,2 can be calculated as:

σ1,2 −0.0056
ρ1,2 = = = −1
σ1 × σ2 0.075 × 0.075
And since it is equal to −1 we know that the portfolio risk is 0, i.e.

ρi,j = −1 ⇒ σp = 0

Exercise 16 You own $1, 000 to invest in two stocks. You invest $600 in Stock 1,
whose expected return is 10% and standard deviation is 15%, and the
remaining $400 in Stock 2, whose expected return is 12% and standard
deviation is 20%. The correlation coefficient between the two stocks’
return is 0.2. What are the expected return and standard deviation of
your investment?

Solution The weights of our investment are:

$600
ω1 = = 0.6
$1, 000

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 and,
$400
ω2 = = 0.4
$1, 000
The expected return of the portfolio is:
E(rp ) = ω1 × E(r1 ) + ω2 × E(r2 ) = 0.6 × 0.1 + 0.4 × 0.12 = 10.8%

And the risk of the portfolio, measure by the standard deviation, is:
σp2 = ω12 σ12 + ω22 σ22 + 2ω1 ω2 ρ1,2 σ1 σ2
σp2 = (0.6)2 (0.15)2 + (0.4)2 (0.2)2 + 2 × (0.6)(0.4)(0.2)(0.15)(0.2)
σp2 = 0.01738 ⇒ σp = 0.1318 = 13.18%
Exercise 17 Compute the covariance of returns between General Motors (GM) and
the market index (M) .
ˆ (i) Can you write out the covariance formula?
ˆ (ii) Can you compute the covariance?

s Economy GM’s return Market return Probability

(rGM,s ) (rM,s ) (ps )
1 Expansion 0.1 0.1 1/3
2 Normal 0.2 0.3 1/3
3 Recession −0.2 −0.3 1/3
Sum: 1

Solution ˆ The covariance formula is:

P3 h

i
σGM,M = s=1 ps × rGM,s − E(rGM ) × rM,s − E(rM )

ˆ To compute the covariance we first need to compute the expected

returns for each asset, i.e. E(rGM ) and E(rM ):
1 1 1
E(rGM ) = × 0.1 + × 0.2 + × (−0.2) = 0.033
3 3 3
1 1 1
E(rM ) = × 0.1 + × 0.3 + × (−0.3) = 0.033
3 3 3
Replacing into the covariance formula we obtain:
3 h
X

i
σGM,M = pi × rGM,s − 0.033) × rM,s − 0.033
s=1

1   1  
= × (0.1 − 0.033) × (0.1 − 0.033) + × (0.2 − 0.033) × (0.3 − 0.033)
3 3
1  
+ × (−0.2 − 0.033) × (−0.3 − 0.033) ⇒ σGM,M = 0.0422
3

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Exercise 18 Consider the following probability distribution of holding period re-
turns for two stocks named A and B:

State of the Economy Probability Return on A Return on B

Expansion 0.4 0.22 0.05
Normal 0.35 0.11 0.07
Recession 0.25 −0.09 0.1

ˆ (i) What are the expected returns for stocks A and B, respec-
tively?
ˆ (ii) What are the standard deviations for stocks A and B, respec-
tively?
ˆ (iii) What is the covariance of returns between stocks A and B?
ˆ (iv) If you invest 40% of your funds in stock A and the remaining
funds in stock B, what are the expected return and the standard
deviation of your portfolio?
ˆ (v) Assume your have $1, 000 to invest. If you sell short $200 of
stock B and buy long stock A using all available funds, what are
the expected return and the standard deviation of your portfolio?
ˆ (vi) What is the relationship between the portfolio’s standard
deviation and the standrd deviations of the two stocks?

Solution ˆ (i) The expected returns for A and B are:

E(RA ) = 0.4 × 0.22 + 0.35 × 0.11 + 0.25 × (−0.09) = 10.4%
E(RB ) = 0.4 × 0.05 + 0.35 × 0.07 + 0.25 × 0.1 = 6.95%
ˆ (ii) The standard deviations for A and B are:
q
σA = 0.4 × (0.22 − 0.104)2 + 0.35 × (0.11 − 0.104)2 + 0.25 × (−0.09 − 0.104)2

σA = 12.17%
q
σB = 0.4 × (0.05 − 0.0695)2 + 0.35 × (0.07 − 0.0695)2 + 0.25 × (0.1 − 0.0695)2

σB = 1.96%

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 ˆ (iii) The covariance between A and B is:
h
i
σA,B = 3i=1 pi × RA,i − E(RA )) × RB,i − E(RB )
P

   
= 0.4× (0.22 − 0.104) × (0.05 − 0.0695) +0.35× (0.11 − 0.104) × (0.07 − 0.0695)
 
+0.25 × (−0.09 − 0.104) × (0.1 − 0.0695)
σA,B = -0.002383
ˆ (iv) Investing 40% in A means: ωA = 0.4 ⇒ ωB = 0.6
The expected return of the portfolio is then:
E(Rp ) = ωA × E(RA ) + ωB × E(RB ) = 0.4 × 10.4% + 0.6 × 6.95%
E(Rp ) = 8.33%
And the standard deviation is:
σp2 = ωA
2 σ2 + ω2 σ2 + 2 × ω ω σ
A B B A B A,B
σp2 = (0.4)2 (12.17%)2 + (0.6)2 (1.96%)2 + 2(0.4)(0.6)(−0.002383)
σp2 = 0.0013642 ⇒ σp = 3.693%
ˆ (v) $200 short of stock B means: ωB = −0.2 ⇒ ωA = 1.2
The expected return of the portfolio is then:
E(Rp ) = ωA × E(RA ) + ωB × E(RB ) = 1.2 × 10.4% − 0.2 × 6.95%
E(Rp ) = 11.09%
And the standard deviation is:
σp2 = ωA
2 σ2 + ω2 σ2 + 2 × ω ω σ
A B B A B A,B
σp2 = (1.2)2 (12.17%)2 +(−0.2)2 (1.96%)2 +2(1.2)(−0.2)(−0.002383)
σp2 = 0.0013642 ⇒ σp = 2.25%
ˆ (vi) The relationship between the portfolio’s standard deviation
and the standrd deviations of the two stocks is:
σp ≤ max(σA , σB )

Exercise 19 Assets A, B, and C are the only assets available with the following
characteristics:

Asset Expected Return Standard Deviation

A 0.1 0.1
B 0.15 0.18
C 0.2 0.2

ˆ (i) Would a risk-averse investor choose to hold an equally weighted

portfolio A and C or hold asset B by itself? Explain

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 ˆ (ii) Assume there is a risk-free asset with a return of 5%. Would
a risk-averse investor choose to hold a combination of A and C or
a combination of the risk-free asset and C? Explain by drawing
the combination lines (or the investment opportunity line) on the
E(r) − −σ graph. Assume that the maximum risk you can take
is 20%.
ˆ (iii) What are the expected return and the standard deviation
of a portfolio consisting of the preceding three stocks with equal
weights, respectively?

Solution ˆ (i) A portfolio containing equally weighted assets A and C has a

return of:
 
E Rp(A,C) = ωA ×E(RA )+ωC ×E(RC ) = 0.5×0.1+0.5×0.2 = 15%

and a standard deviation of:

σp2(A,C) = ωA
2 2 2 2
σA + ωC σC + 2 × ωA ωC ρ(A,C) σA σC
Since the standard deviation and return of A and C belong to the
curve E(R) = σ (as shown below), we can assume that A and C
are strongly correlated (i.e. ρ(A,C) = 1)

Asset distribution in the Risk/Return space

0.4
E(R) = σ
Asset A
0.3 Asset B
Asset C
Return E(R)

0.2

0.1

0
0 0.1 0.2 0.3 0.4
Risk σ

We can then calculate the standard deviation of the portfolio as

follows:
σp2(A,C) = (0.5)2 (0.1)2 +(0.5)2 (0.2)2 +2×(0.5)(0.5)(1)(0.1)(0.2) = 0.0225

σp(A,C) = 15%

8
 Now, since:
 
σp(A,C) = 15% < σB = 18% and E Rp(A,C) = E(RB ) = 15%

A risk-averse investor would choose the portfolio containing assets

A and C over asset B by itself.

ˆ (ii) A portfolio containing a risk-free asset with rf = 5% and

asset C has an expected value equal to:
 
E Rp(r ,C) = ωrf ×rf +ωC ×E(RC ) = (1−ωC )×rf +ωC ×E(RC )
f

The standard deviation of the portfolio can be then calculated as

follows:

σp2(r = (1 − ωC )2 σr2f + ωC
2 2 2 2
σC + 2 × (1 − ωC )ωC σ(rf ,c) = ωC σC
f ,C)

From here we obtain:

σp(r
f ,C)
σp(r = ωC σ C ⇒ ωC =
f ,C) σC
And replacing into the expected value we finally get:
 
E(RC ) − rf
E(Rp(r ,C) ) = rf + σp(r ,C) = 5% + 75% × σp(r ,C)
f σC f f

This result is plotted below:

Asset distribution in the Risk/Return space

0.5
E(R) = σ
E(Rp(r ,C) )
f
0.4 Asset A
Asset B
Return E(R)

0.3 Asset C
rf Asset

0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5
Risk σ

9
 We can observe from the graph that a portfolio containing the
risk-free asset and asset C, yields better returns for at same risks
as the portfolio containing assets A and C.

We can verify this by assuming a maximum risk of 20%, i.e.

σp(r ,C) = 0.2. Then, the weights and return of the portfolio
f
would be:
0.2  
ωC = = 1 ⇒ E Rp(r ,C) = E(RC ) = 20%
0.2 f

We know, from the previous point, that:

σp(A,C) = 15%

and  
E Rp(A,C) = 15%

In order to obtain the same risk as the portfolio containing as-

sets A and C, we calculate the weights and return of the current
portfolio as follows:
0.15    
ωC = = 0.75 ⇒ E Rp(r ,C) = 5%+75%×15% = 16.25% > E Rp(A,C) = 15%
0.2 f

Now, since for equal risks we obtain better returns, this shows
that:

A risk-averse investor would choose the portfolio containing the risk-free

asset and asset C, over the portfolio containing assets A and C.

ˆ (iii) A portfolio containing all (equally-weighted ) stocks, has an

expected return of:
  1   1
E Rp(A,B,C) = × E(RA ) + E(RB ) + E(RC ) = ×[0.1+0.15+0.2] = 15%
3 3
In order to find the standard deviation of the portfolio we need
to solve:

σp2(A,B,C) = ωA
2 2 2 2
σA +ωB 2 2
σB +ωC σC +2×ωA ωB σ(A,B) +2×ωB ωC σ(B,C) +2×ωA ωC σ(A,C)

Unfortunately, we do not have enough information to calculate

σ(A,B) , σ(B,C) , and σ(A,C) ; and as such:

It is not possible to calculate the standard deviation of the portfolio.

10
Exercise 20 Assume that you are considering selecting assets from among the fol-
lowing four candidates:
Market Ass. 1 Prob. Ass. 2 Prob. Ass. 3 Prob. Rainfall Ass. 4 Prob.
Condition Ret. Ret. Ret. Ret.
Good 16 1/4 4 1/4 20 1/4 Plentiful 16 1/3
Average 12 1/2 6 1/2 14 1/2 Average 12 1/3
Poor 8 1/4 8 1/4 8 1/4 Light 8 1/3

Assume that there is no relationship between the amount of rainfall

and the condition of the stock market.

ˆ (i) Solve for the expected return and the standard deviation of
return for each separate investment.
ˆ (ii) Solve for the correlation coefficient and the covariance be-
tween each pair of investments.
ˆ (iii) Solve for the expected return and variance of each of the
portfolios shown in the following.

Portfolio Asset 1 Asset 2 Asset 3 Asset 4

A 1/2 1/2
B 1/2 1/2
C 1/2 1/2
D 1/2 1/2
E 1/2 1/2
F 1/3 1/3 1/3
G 1/3 1/3 1/3
H 1/3 1/3 1/3
I 1/4 1/4 1/4 1/4

ˆ (iv) Plot the original assets and each of the portfolios from (iii)
in expected return standard deviation space.

Solution ˆ (i) The expected return and standard deviation for each invest-
ment is calculated as follows:

E(r1 ) = 14 × 16% + 12 × 12% + 14 × 8% = 12%

r
1 1 1
σ1 = × (16% − 12%)2 + × (12% − 12%)2 + × (8% − 12%)2 = 2.83%
4 2 4

E(r2 ) = 14 × 4% + 12 × 6% + 14 × 8% = 6%
r
1 1 1
σ2 = × (4% − 6%)2 + × (6% − 6%)2 + × (8% − 6%)2 = 1.41%
4 2 4

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 1 1 1
E(r3 ) = 4 × 20% + 2 × 14% + 4 × 8% = 14%
r
1 1 1
σ3 = × (20% − 14%)2 + × (14% − 14%)2 + × (8% − 14%)2 = 4.24%
4 2 4

1 1 1
E(r4 ) = 3 × 16% + 3 × 12% + 3 × 8% = 12%
r
1 1 1
σ4 = × (16% − 12%)2 + × (12% − 12%)2 + × (8% − 12%)2 = 3.27%
3 3 3

ˆ (ii) The covariance between assets i and j is:

P3 h

i
σi,j = k=1 pk × Ri,k − E(Ri )) × Rj,k − E(Rj )

And the correlation coefficient between assets i and j is:

σi,j
ρi,j = σi ×σj

So we have:
1   1  
σ1,2 = × (16% − 12%) × (4% − 6%) + × (12% − 12%) × (6% − 6%)
4 2
1   −0.0004
+ × (8% − 12%) × (8% − 6%) = -0.0004 ⇒ ρ1,2 = = -1
4 0.0283 × 0.0141

1   1  
σ1,3 = × (16% − 12%) × (20% − 14%) + × (12% − 12%) × (14% − 14%)
4 2
1   0.0012
+ × (8% − 12%) × (8% − 14%) = 0.0012 ⇒ ρ1,3 = = 1
4 0.0283 × 0.0424

1   1  
σ2,3 = × (4% − 6%) × (20% − 14%) + × (6% − 6%) × (14% − 14%)
4 2
1   0.0012
+ × (8% − 6%) × (8% − 14%) = -0.0006 ⇒ ρ2,3 = = -1
4 0.0141 × 0.0424

The covariances σ1,4 , σ2,4 , and σ3,4 cannot be calculated since the
corresponding probabilities do not match.

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ˆ (iii) The expected returns of the portfolios are:
1 1
E(rA ) = 2 × 12% + 2 × 6% = 9%
1 1
E(rB ) = 2 × 12% + 2 × 14% = 13%
1 1
E(rC ) = 2 × 12% + 2 × 12% = 12%
1 1
E(rD ) = 2 × 6% + 2 × 14% = 10%
1 1
E(rE ) = 2 × 14% + 2 × 12% = 13%
1 1 1
E(rF ) = 3 × 12% + 3 × 6% + 3 × 14% = 10.67%
1 1 1
E(rG ) = 3 × 6% + 3 × 14% + 3 × 12% = 10.67%
1 1 1
E(rH ) = 3 × 12% + 3 × 14% + 3 × 12% = 12.67%
1 1 1 1
E(rI ) = 4 × 12% + 4 × 6% + 4 × 14% + 4 × 12% = 11%

And the variances of the portfolios are:

2
σA = (0.5)2 (0.0283)2 +(0.5)2 (0.0141)2 +2(0.5)(0.5)(−1)(0.0283)(0.0141) = 0.005%

2
σB = (0.5)2 (0.0283)2 +(0.5)2 (0.0424)2 +2(0.5)(0.5)(1)(0.0283)(0.0424) = 0.125%
2
σD = (0.5)2 (0.0141)2 +(0.5)2 (0.0424)2 +2(0.5)(0.5)(−1)(0.0141)(0.0424) = 0.0798%
 2  2  2   
2 1 2 1 1 2 1 1
σF = (0.0283) + + (0.0424) +2× (−1)(0.0283)(0.0141)
3 3 3 3 3
     
1 1 1 1
+2× (1)(0.0283)(0.0424)+2× (−1)(0.0141)(0.0424) = 0.0356%
3 3 3 3
2 = Not possible → ∄ σ
σC 1,4
2 = Not possible → ∄ σ
σE 3,4
2 = Not possible → ∄ σ
σG 2,4 and σ3,4
2 = Not possible → ∄ σ
σH 1,4 and σ3,4

σI2 = Not possible → ∄ σ1,4 , σ2,4 and σ3,4

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ˆ (iv) We can calculate the standard deviation for portfolios A, B,
D and F as follows:
2
σA = 0.005% ⇒ σA = 0.707%

2
σB = 0.125% ⇒ σB = 3.54%
2
σD = 0.0798% ⇒ σD = 2.82%
,
2
σD = 0.0356% ⇒ σD = 1.89%

plot the original assets and each of the portfolios from (iii) in a
graph of expected return vs. standard deviation:

Asset and Portfolio distribution in the Risk/Return space

4 Asset 1
Asset 2
Asset 3
Return E(R)(%)

Asset 4
3 Portfolio A
Portfolio B
Portfolio D
2 Portfolio F

6 8 10 12 14
Risk σ(%)

The data is as follows:

Asset/Portfolio Expected Return (%) Standard Deviation (%)

1 12 2.83
2 6 1.41
3 14 4.24
4 12 3.27
A 9 0.707
B 13 3.54
D 10 2.82
F 10.67 1.89

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